UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
For The Quarterly Period Ended September 30, 2007
OR
Commission File Number: 814-00702
HERCULES TECHNOLOGY GROWTH CAPITAL, INC.
(Exact Name of Registrant as Specified in its Charter)
(State or Jurisdiction of
Incorporation or Organization)
(IRS Employer
Identification No.)
(650) 289-3060
(Registrant’s Telephone Number, Including Area Code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods as the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large Accelerated Filer ¨ Accelerated Filer x Non-Accelerated Filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) YES ¨ NO x
On November 7, 2007, there were 32,541,080 shares outstanding of the Registrant’s common stock, $0.001 par value.
TABLE OF CONTENTS
PART I.
Item 1.
Consolidated Financial Statements
Consolidated Statements of Assets and Liabilities as of September 30, 2007 (unaudited) and December 31, 2006
Consolidated Schedule of Investments as of September 30, 2007 (unaudited)
Consolidated Schedule of Investments as of December 31, 2006
Consolidated Statements of Operations for the three and nine-month periods ended September 30, 2007 and 2006 (unaudited)
Consolidated Statements of Changes in Net Assets for the nine-month periods ended September 30, 2007 and 2006 (unaudited)
Consolidated Statements of Cash Flows for the nine-month periods ended September 30, 2007 and 2006 (unaudited)
Notes to Consolidated Financial Statements (unaudited)
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Item 4.
Controls and Procedures
PART II.
Legal Proceedings
Item 1a.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Submission of Matters to a Vote of Security Holders
Item 5.
Other Information
Item 6.
Exhibits
Signatures
PART I: FINANCIAL INFORMATION
In this Quarterly Report, the “Company,” “Hercules,” “we,” “us” and “our” refer to Hercules Technology Growth Capital, Inc. and its wholly owned subsidiaries and its affiliated securitization trusts unless the context otherwise requires.
CONSOLIDATED STATEMENTS OF ASSETS AND LIABILITIES
Assets
Investments, at value (cost of $412,824,423 and $279,946,465, respectively)
Deferred loan origination revenue
Cash and cash equivalents
Interest receivable
Other assets
Total assets
Liabilities
Accounts payable
Accrued liabilities
Short-term loans payable
Long-term loans payable
Total liabilities
Net assets
Net assets consist of:
Par value
Capital in excess of par value
Deferred stock compensation
Unrealized appreciation on investments
Accumulated realized losses on investments
Distributions in excess of investment income
Total net assets
Shares of common stock issued and outstanding ($0.001 par value, 60,000,000 authorized)
Net asset value per share
See notes to consolidated financial statements (unaudited).
3
CONSOLIDATED SCHEDULE OF INVESTMENTS
September 30, 2007
(unaudited)
Portfolio Company
Industry
Type of Investment(1)(6)
Principal
Amount
Acceleron Pharmaceuticals, Inc. (0.98%)*(4)
Matures June 2009
Interest rate 10.25%
Preferred Stock Warrants
Acceleron Pharmaceuticals, Inc. (0.29%)
Total Acceleron Pharmaceuticals, Inc.
Aveo Pharmaceuticals, Inc. (3.39%)(4)
Matures September 2009
Interest rate 10.75%
Total Aveo Pharmaceuticals, Inc.
Elixir Pharmaceuticals, Inc. (3.85%)(4)
Matures June 2010
Interest rate Prime + 2.45%
Total Elixir Pharmaceuticals, Inc.
EpiCept Corporation (2.23%)(4)
Matures August 2009
Interest rate 11.70%
Short Term Receivable
Common Stock Warrants
Total EpiCept Corporation
Inotek Pharmaceuticals Corp. (0.38%)
Total Inotek Pharmaceuticals Corp.
Memory Pharmaceticals Corp. (2.60%) (4)
Matures February 2011
Interest rate 11.45%
Total Memory Pharmaceticals Corp.
Merrimack Pharmaceuticals, Inc. (1.13%)(4)
Matures October 2008
Interest rate 11.15%
Total Merrimack Pharmaceuticals, Inc.
Neosil, Inc. (0.51%)
Matures May 2010
Total Neosil, Inc.
Paratek Pharmaceuticals, Inc. (0.93%)(4)
Matures June 2008
Interest rate 11.10%
Total Paratek Pharmaceuticals, Inc.
Portola Pharmaceuticals, Inc. (3.86%)(4)
Matures September 2010
Interest rate Prime + 1.75%
Total Portola Pharmaceuticals, Inc.
4
(continued)
Sirtris Pharmaceuticals, Inc. (2.73%)(4)
Matures April 2011
Interest rate 10.60%
Sirtris Pharmaceuticals, Inc. (0.25%)
Total Sirtris Pharmaceuticals, Inc.
Total Drug Discovery (23.13%)
IKANO Communications, Inc. (5.59%)
Senior Debt
Matures March 2011
Interest rate 11.00%
Total IKANO Communications, Inc.
Interwise, Inc. (0.13%)(4)
Total Interwise, Inc.
Ping Identity Corporation (0.51%)(4)
Interest rate 11.50%
Total Ping Identity Corporation
Purcell Systems, Inc. (2.15%)
Interest rate Prime + 3.50%
Revolving Line of Credit
Interest rate Prime + 2.00%
Total Purcell Systems, Inc.
Rivulet Communications, Inc. (0.91%)(4)
Rivulet Communications, Inc. (0.06%)
Total Rivulet Communications, Inc.
Seven Networks, Inc. (3.08%)
Matures April 2010
Interest rate Prime + 3.75%
Matures April 2008
Interest rate Prime + 3.00%
Total Seven Networks, Inc.
Simpler Networks Corp. (1.04%)(4)
Matures July 2009
Interest rate 11.75%
Simpler Networks Corp. (0.06%)
Total Simpler Networks Corp.
Stoke, Inc. (0.19%)
Matures August 2010
Interest rate 10.55%
Total Stoke, Inc.
5
Tectura Corporation (5.49%)
Matures March 2012
Interest rate LIBOR + 6.15%
Matures March 2008
Interest rate LIBOR + 5.15%
Total Tectura Corporation
Teleflip, Inc. (0.19%)
Interest rate Prime + 2.75%
Total Teleflip, Inc.
Wireless Channels, Inc. (3.16%)
Senior Debt -Second Lien
Interest rate 9.25%
Interest rate Prime + 4.25%
Total Wireless Channels, Inc.
Total Communications & Networking (22.56%)
Atrenta, Inc. (1.13%)(4)
Atrenta, Inc. (0.06%)
Preferred Stock
Total Atrenta, Inc.
Blurb, Inc. (0.64%)
Matures December 2009
Interest rate 9.55%
Total Blurb, Inc.
Cittio, Inc. (0.26%)
Total Cittio, Inc.
Compete, Inc. (0.73%)(4)
Matures March 2009
Total Compete, Inc.
Forescout Technologies, Inc. (0.71%)(4)
Matures August 2007
Interest rate Prime + 1.49%
Total Forescout Technologies, Inc.
GameLogic, Inc. (0.76%)(4)
Interest rate Prime + 4.125%
Total GameLogic, Inc.
6
Gomez, Inc. (0.10%)(4)
Matures December 2007
Interest rate 12.25%
Total Gomez, Inc.
HighRoads, Inc. (0.01%)(4)
Total HighRoads, Inc.
Intelliden, Inc. (0.68%)
Matures February 2010
Interest rate 13.20%
Total Intelliden, Inc.
Oatsystems, Inc. (1.26%)(4)
Total Oatsystems, Inc.
Proficiency, Inc. (0.51%)(5)
Matures July 2008
Interest rate 12.00%
Total Proficiency, Inc.
PSS Systems, Inc. (0.90%)(4)
Matures March 2010
Interest rate 10.74%
Total PSS Systems, Inc.
Savvion, Inc. (1.66%)(4)
Interest rate Prime + 3.45%
Total Savvion, Inc.
Sportvision, Inc. (0.01%)
Total Sportvision, Inc.
Talisma Corp. (0.00%)(4)
Software
Total Talisma Corp.
Total Software (9.42%)
Agami Systems, Inc. (1.49%)(4)
Total Agami Systems, Inc.
7
Luminus Devices, Inc. (3.03%)(4)
Electronics &
Computer Hardware
Interest rate 12.50%
Total Luminus Devices, Inc.
NetEffect, Inc. (0.64%)
Interest rate 11.95%
Total NetEffect, Inc.
NeoScale Systems, Inc. (0.72%)
Matures October 2009
Total NeoScale Systems, Inc.
SiCortex, Inc. (0.51%)
Matures December 2010
Interest rate 10.95%
Total SiCortex, Inc.
Sling Media, Inc. (0.50%)
Sling Media, Inc. (0.24%)
Total Sling Media, Inc.
VeriWave, Inc. (1.09%)
Total VeriWave, Inc.
ViDeOnline Communications, Inc. (0.08%)(4)
Total ViDeOnline Communications, Inc.
Total Electronics & Computer Hardware (8.30%)
Aegerion Pharmaceuticals, Inc. (2.57%) (4)
Specialty
Pharmaceuticals
Interest rate Prime + 2.50%
Total Aegerion Pharmaceuticals, Inc.
Quatrx Pharmaceuticals Company (3.94%)(4)
Matures January 2010
Quatrx Pharmaceuticals Company (0.19%)
Total Quatrx Pharmaceuticals Company
Panacos Pharmaceuticals, Inc. (2.49%)
Matures January 2011
Interest rate 11.20%
Total Panacos Pharmaceuticals, Inc.
Total Specialty Pharmaceuticals (9.19%)
8
BabyUniverse, Inc. (1.25%)(4)
Interest rate Prime + 2.35%
Total BabyUniverse, Inc.
Market Force Information, Inc. (0.40%)(4)
Matures May 2009
Interest rate 10.45%
Market Force Information, Inc. (0.13%)
Total Market Force Information, Inc.
Wageworks, Inc. (0.28%)(4)
Wageworks, Inc. (0.05%)
Total Wageworks, Inc.
Total Consumer & Business Products (2.11%)
Ageia Technologies, Inc. (1.42%)(4)
Matures August 2008
Convertible Debt
Ageia Technologies, Inc. (0.00%)
Total Ageia Technologies
Custom One Design, Inc. (0.26%)
Total Custom One Design, Inc.
iWatt Inc. (1.26%)(4)
Matures September 2007
Total iWatt Inc.
NEXX Systems, Inc. (3.34%)(4)
Total NEXX Systems, Inc.
Quartics, Inc. (0.08%)
Interest rate 11.05%
Total Quartics, Inc.
Solarflare Communications, Inc. (0.16%)
Solarflare Communications, Inc. (0.13%)
Total Solarflare Communications, Inc.
Total Semiconductors (6.65%)
9
Labopharm USA, Inc. (0.93%)(4)(5)
Total Labopharm USA, Inc.
Transcept Pharmaceuticals, Inc. (2.08%)(4)
Interest rate 10.69%
Transcept Pharmaceuticals, Inc. (0.13%)
Total Transcept Pharmaceuticals, Inc.
Total Drug Delivery (3.14%)
BARRX Medical, Inc. (0.38%)
Total BARRX Medical, Inc.
EKOS Corporation (1.28%)
Matures November 2010
Total EKOS Corporation
Gynesonics, Inc. (0.45%)(4)
Interest rate 9.50%
Gynesonics, Inc. (0.06%)
Total Gynesonics, Inc.
Novasys Medical, Inc. (1.94%)(4)
Interest rate 9.70%
Total Novasys Medical, Inc.
Power Medical Interventions, Inc. (0.01%)
Total Power Medical Interventions, Inc.
Total Therapeutic (4.12%)
Hedgestreet, Inc. (0.73%)(4)
Interest rate 11.30%
Total Hedgestreet, Inc.
Invoke Solutions, Inc. (0.56%)(4)
Matures December 2008
Interest rate 11.25%
Total Invoke Solutions, Inc.
Prism Education Group Inc. (0.51%)
Total Prism Education Group Inc.
RazorGator Interactive Group, Inc. (0.57%)(4)
Matures January 2008
Interest rate 9.95%
RazorGator Interactive Group, Inc. (0.44%)
Total RazorGator Interactive Group, Inc.
10
Serious USA, Inc. (0.68%)
Total Serious USA, Inc.
Total Internet Consumer & Business Services (3.49%)
Lilliputian Systems, Inc. (2.02%)(4)
Interest rate 9.75%
Total Lilliputian Systems, Inc.
Total Energy (2.02%)
Active Response Group, Inc. (2.57%)
Interest rate LIBOR + 6.55%
Total Active Response Group, Inc.
Buzznet, Inc. (0.29%)
Total Buzznet, Inc.
Solutionary, Inc. (1.67%)
Interest rate LIBOR + 5.50%
Interest rate LIBOR + 5.00%
Solutionary, Inc. (0.07%)
Total Solutionary, Inc.
Wallop Technologies, Inc. (0.06%)
Interest rate 10.00%
Total Wallop Technologies, Inc.
Total Information Services (4.66%)
Novadaq Technologies, Inc. (0.35%)
Total Novadaq Technologies, Inc.
Optiscan Biomedical, Corp. (0.11%)(4)
Interest rate 15.00%
Optiscan Biomedical, Corp. (0.26%)
Total Optiscan Biomedical, Corp.
Total Diagnostic (0.72%)
11
Guava Technologies, Inc. (1.57%)(4)
Interest rate Prime + 3.25%
Total Guava Technologies, Inc.
NuGEN Technologies, Inc. (0.51%)
Total NuGEN Technologies, Inc.
Total Biotechnology Tools (2.08%)
Rubicon Technology Inc. (1.57%) (4)
Interest rate Prime + 3.375%
Interest rate Prime + 0.25%
Total Rubicon Technology Inc.
Total Advanced Specialty Materials & Chemicals (1.57%)
Crux Biomedical, Inc. (0.06%)
Total Crux Biomedical, Inc.
Diomed Holdings, Inc. (1.54%)
Matures July 2010
Total Diomed Holdings, Inc.
Total Surgical Devices (1.60%)
Waterfront Media Inc. (1.64%) (4)
Interest rate Prime + 1.25%
Waterfront Media Inc. (0.26%)
Total Waterfront Media Inc.
Total Media/Content/Info (1.90%)
Total Investments (106.66%)
12
December 31, 2006
Type of Investment(1)(7)
Acceleron Pharmaceuticals, Inc. (1.74%)*(4)
Acceleron Pharmaceuticals, Inc. (0.44%)
Total Acceleron Pharmaceuticals, Inc
Aveo Pharmaceuticals, Inc. (5.88%)(4)
Total Aveo Pharmaceuticals, Inc
Elixir Pharmaceuticals, Inc. (3.92%)
EpiCept Corporation (3.84%)
Guava Technologies, Inc. (2.26%)(4)
Total Guava Technologies, Inc
Labopharm USA, Inc. (2.58%)(4)(5)
Merrimack Pharmaceuticals, Inc. (2.61%)(4)
Convertible Senior Debt
Paratek Pharmaceuticals, Inc. (2.62%)(4)
Portola Pharmaceuticals, Inc. (4.41%) .
Total Portola Pharmaceuticals, Inc
Quatrx Pharmaceuticals Company (7.05%)(4)
Sirtris Pharmaceuticals, Inc. (3.91%)(4)
13
TransOral Pharmaceuticals, Inc. (3.92%)(4)
Total TransOral Pharmaceuticals, Inc.
Total Biopharmaceuticals (45.18%)
Atrenta, Inc. (2.03%)(4)
Atrenta, Inc. (0.10%)
Total Atrenta, Inc
Blurb, Inc. (0.10%)
Total Blurb, Inc
Compete, Inc. (1.52%)(4)
Forescout Technologies, Inc. (0.78%)
GameLogic, Inc. (1.17%)(4)
Total GameLogic, Inc
Gomez, Inc. (0.48%)(4)
HighRoads, Inc. (0.77%)(4)
Matures February 2009
Interest rate 11.65%
Total HighRoads, Inc
Intelliden, Inc. (1.17%)
Inxight Software, Inc. (1.60%)(4)
Matures February 2008
Total Inxight Software, Inc.
Oatsystems, Inc. (2.36%)(4)
Proficiency, Inc. (1.43%)(5)
14
Savvion, Inc. (1.58%)(4)
Matures March 2007
Total Savvion, Inc
Talisma Corp. (0.74%)(4)
Subordinated Debt
Total Talisma Corp
Total Software (15.84%)
BabyUniverse, Inc. (1.90%)(4)
Total BabyUniverse, Inc
Market Force Information, Inc. (0.70%)(4)
Total Market Force Information, Inc
Wageworks, Inc. (5.89%)(4)
Matures November 2008
Interest rate Prime + 4.00%
Wageworks, Inc. (0.10%)
Total Wageworks, Inc
Total Consumer & Business Products (8.59%)
IKANO Communications, Inc. (0.03%)
Communications
& Networking
Interwise, Inc. (0.83%)(4)
Interest rate 17.50%
Total Interwise, Inc
Pathfire, Inc. (1.84%)(4)
Interest rate Prime + 3.65%
Total Pathfire, Inc
Ping Identity Corporation (1.05%)(4)
Rivulet Communications, Inc. (1.37%)(4)
Rivulet Communications, Inc. (0.10%)
Simpler Networks Corp. (2.20%)(4)
Simpler Networks Corp. (0.20%)
Total Communications & Networking (7.62%)
15
Adiana, Inc. (0.53%)(4)
Interest rate Prime + 6.00%
Adiana, Inc. (0.20%)
Total Adiana, Inc.
BARRX Medical, Inc. (0.59%)
Gynesonics, Inc. (0.80%)
Novasys Medical, Inc. (3.13%)(4)
Optiscan Biomedical, Corp. (0.40%)(4)
Optiscan Biomedical, Corp. (0.39%)
Total Optiscan Biomedical, Corp
Xillix Technologies Corp. (1.53%)(4)(5)(6)
Interest rate 12.40%
Total Xillix Technologies Corp
Total Medical Devices & Equipment (7.58%)
Hedgestreet, Inc. (1.67%)(4)
Invoke Solutions, Inc. (0.97%)(4)
RazorGator Interactive Group, Inc. (1.25%)(4)
RazorGator Interactive Group, Inc. (0.67%)
Total Internet Consumer & Business Services (4.56%)
Agami Systems, Inc. (2.75%)(4)
16
Cornice, Inc. (1.44%)(4)
Interest rate Prime + 4.50%
Total Cornice, Inc.
Luminus Devices, Inc. (5.88%)(4)
NeoScale Systems, Inc. (1.17%)(4)
Total NeoScale Systems, Inc
Sling Media, Inc. (0.56%)
ViDeOnline Communications, Inc. (0.18%)(4)
Total Electronics & Computer Hardware (11.98%)
Ageia Technologies, Inc. (2.76%)(4)
Ageia Technologies, Inc. (0.20%)
Cradle Technologies (0.02%)
Total Cradle Technologies
iWatt Inc. (1.27%)(4)
NEXX Systems, Inc. (1.96%)(4)
Total Semiconductors (6.21%)
Lilliputian Systems, Inc. (3.33%)(4)
Total Energy (3.33%)
Total Investments (110.89%)
17
See notes to consolidated financial statements.
18
CONSOLIDATED STATEMENTS OF OPERATIONS
Investment income:
Interest
Fees
Total investment income
Operating expenses:
Loan fees
General and administrative
Employee Compensation:
Compensation and benefits
Stock-based compensation
Amortization of restricted stock awards
Total employee compensation
Total operating expenses
Net investment income before provision for income taxes and investment gains and losses
Provision (benefit) for income taxes
Net investment income
Net realized gain (loss) on investments
Net increase (decrease) in unrealized appreciation on investments
Net realized and unrealized gain (loss)
Net increase in net assets resulting from operations
Net investment income before provision for income taxes and investment gains and losses per common share:
Basic
Diluted
Change in net assets per common share:
Weighted average shares outstanding
19
CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
Capital in
excess of
par value
Deferred Stock
Compensation
Unrealized
Appreciation
on Investments
Accumulated
Realized Gains
(Losses)
Distributions
in Excess of
Investment Income
Balance at December 31, 2005.
Net increase in stockholders’ equity resulting from operations
Issuance of common shares
Issuance of common shares in Rights Offering, net of offering costs
Issuance of common stock under dividend reinvestment plan
Dividends declared
Balance at September 30, 2006
Balance at December 31, 2006
Issuance of common stock
Issuance of common stock in public offerings, net of offering costs
Issuance of common stock from warrant exercises
Issuance of common stock under restricted stock plan
Balance at September 30, 2007
20
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash flows from operating activities:
Adjustments to reconcile net increase in net assets resulting from operations to net cash used in operating activities:
Purchase of investments
Principal payments received on investments
Proceeds from sale of investments
Net unrealized appreciation on investments
Net unrealized appreciation on investments due to lender
Net realized loss on investments
Accretion of loan discounts
Accretion of loan exit fees
Depreciation
Common stock issued in lieu of Director compensation
Amortization of deferred loan origination revenue
Change in operating assets and liabilities:
Prepaid expenses and other assets
Income tax receivable
Deferred tax asset
Income tax payable
Net cash used in operating activities
Cash flows from investing activities:
Purchases of capital equipment
Other long-term assets
Net cash used in investing activities
Cash flows from financing activities:
Proceeds from issuance of common stock, net
Dividends paid
Borrowings of credit facilities
Repayments of credit facilities
Fees paid for credit facilities and debentures
Net cash provided by financing activities
Net increase (decrease) in cash
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
21
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Description of Business and Unaudited Interim Consolidated Financial Statements Basis of Presentation
Hercules Technology Growth Capital, Inc. (the “Company”) is a specialty finance company that provides debt and equity growth capital to technology-related and life-science companies at all stages of development from seed and emerging growth to expansion and established stages of development, including expanding into select publicly listed companies and lower middle market companies. The Company sources its investments through its principal office located in Silicon Valley, as well as through its additional offices in the Boston, Massachusetts, Boulder, Colorado, Chicago, Illinois, Costa Mesa, California and Columbus, Ohio areas. The Company was incorporated under the General Corporation Law of the State of Maryland in December 2003. The Company commenced operations on February 2, 2004 and commenced investment activities in September 2004.
The Company is an internally managed, non-diversified closed-end investment company that has elected to be regulated as a business development company (“BDC”) under the Investment Company Act of 1940, as amended (the “1940 Act”). From incorporation through December 31, 2005, the Company was taxed as a corporation under Subchapter C of the Internal Revenue Code of 1986, (the “Code”). Effective January 1, 2006, the Company has elected to be treated for tax purposes as a regulated investment company, or RIC, under the Code (see Note 4).
In January 2005, the Company formed Hercules Technology II, L.P. (“HT II”) and Hercules Technology SBIC Management, LLC (HTM). On September 27, 2006, HT II was licensed to operate as a Small Business Investment Company (“SBIC”) under the authority of the Small Business Administration (“SBA”). As an SBIC, the Fund is subject to a variety of regulations concerning, among other things, the size and nature of the companies in which it may invest and the structure of those investments. HTM is a wholly-owned subsidiary of the Company. The Company is the sole limited partner of HT II and HTM is the general partner. (see Note 3).
In July 2005, the Company formed Hercules Funding I LLC and Hercules Funding Trust I, an affiliated statutory trust, and executed a securitized credit facility with Citigroup Global Markets Realty Corp. (see Note 3).
In December 2006, the Company established Hydra Management LLC and Hydra Management Co. Inc., a general partner and investment management group, respectively, should it determine in the future to pursue a relationship with an externally managed fund.
The consolidated financial statements include the accounts of the Company and its subsidiaries. All inter-company accounts and transactions have been eliminated in consolidation. The accompanying consolidated interim financial statements are presented in conformity with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information, and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain disclosures accompanying annual consolidated financial statements prepared in accordance with U.S. GAAP are omitted. In the opinion of management, all adjustments consisting solely of normal recurring accruals considered necessary for the fair presentation of consolidated financial statements for the interim period, have been included. The current period’s results of operations are not necessarily indicative of results that ultimately may be achieved for the year. Therefore, the interim unaudited consolidated financial statements and notes should be read in conjunction with the audited consolidated financial statements and notes thereto for the period ended December 31, 2006. Financial statements prepared on a U.S. GAAP basis require management to make estimates and assumptions that affect the amounts and disclosures reported in the consolidated financial statements and accompanying notes. Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed herein. Certain prior period information has been reclassified to conform to current period presentation.
2. Valuation of Investments
Value is defined in Section 2(a)(41) of the 1940 Act, as (i) the market price for those securities for which a market quotation is readily available and (ii) for all other securities and assets, fair value is as determined in good faith by the Board of Directors. Because the Company invests primarily in structured mezzanine debt investments (“debt”) and equity growth capital (“equity”) of privately-held technology-related and life-science companies backed by leading venture capital and private equity firms, the Company values substantially all of its investments at fair value, as determined in good faith by the Board of Directors in accordance with established valuation policies and consistently applied procedures and the recommendations of the Valuation Committee of the Board of Directors. At September 30, 2007, approximately 93% of the Company’s total assets represented investments in portfolio companies of which greater than 98% are valued at fair value by the Board of Directors.
22
Estimating fair value requires that judgment be applied to the specific facts and circumstances of each portfolio investment. Fair value is the amount for which an investment could be exchanged in an orderly disposition over a reasonable period of time between willing parties other than in a forced or liquidation sale. Due to the inherent uncertainty in the valuation of debt and equity investments that do not have a readily available market value, the fair value established in good faith by the Board of Directors may differ significantly from the values that would have been used had a ready market for the securities existed, and the differences could be material. In addition, changes in the market environment and other events that may occur over the life of the investments may cause the gains or losses ultimately realized on these investments to be different than the valuations currently assigned.
When originating a debt instrument, the Company expects to receive warrants or other equity-related securities from the borrower. The Company determines the cost basis of the warrants or other equity-related securities received based upon their respective fair values on the date of receipt in proportion to the total fair value of the debt and warrants or other equity-related securities received.
At each reporting date, privately held debt and equity securities are valued based on an analysis of various factors including, but not limited to, the portfolio company’s operating performance and financial condition and general market conditions that could impact the valuation. When an external event occurs, such as a purchase transaction, public offering, or subsequent equity sale, the pricing indicated by that external event is utilized to corroborate the Company’s valuation of the debt and equity securities. An unrealized loss is recorded when an investment has decreased in value, including: where collection of a loan is doubtful, there is an adverse change in the underlying collateral or operational performance, there is a change in the borrower’s ability to pay, or there are other factors that lead to a determination of a lower valuation for the debt or equity security. Conversely, an unrealized appreciation is recorded when the investment has appreciated in value. Securities that are traded in the over the counter markets or on a stock exchange will be valued at the prevailing bid price at period end. The Board of Directors estimated the fair value of warrants and other equity-related securities in good faith using a Black-Scholes pricing model and consideration of the issuer’s earnings, sales to third parties of similar securities, the comparison to publicly traded securities, and other factors. Any resulting discount on the loan from initial recordation of the warrant or other equity instruments is accreted into interest income over the life of the loan.
As required by the 1940 Act, the Company classifies its investments by level of control. “Control Investments” are defined in the 1940 Act as investments in those companies that the Company is deemed to “Control.” Generally, under 1940 Act, the Company is deemed to “Control” a company in which it has invested if it owns 25% or more of the voting securities of such company or has greater than 50% representation on its board. “Affiliate Investments” are investments in those companies that are “Affiliated Companies” of the Company, as defined in the 1940 Act, which are not Control Investments. The Company is deemed to be an “Affiliate” of a company in which it has invested if it owns 5% or more but less than 25% of the voting securities of such company. “Non-Control/Non-Affiliate Investments” are those investments that are neither Control Investments nor Affiliate Investments. At September 30, 2007 and December 31, 2006, all of the Company’s investments were in Non-Control/Non-Affiliate companies.
Security transactions are recorded on the trade-date basis.
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A summary of the composition of the Company’s investment portfolio as of September 30, 2007 and December 31, 2006 at fair value is shown as follows:
Senior debt with warrants
Preferred stock
Senior debt-second lien with warrants
Common Stock
Subordinated debt with warrants
A Summary of the Company’s investment portfolio, at value, by geographic location is as follows:
United States
Canada
Israel
The following table shows the fair value of our portfolio by industry sector at September 30, 2007 and December 31, 2006 (excluding unearned income):
Drug discovery
Communications & networking
Specialty pharmaceuticals
Electronics & computer hardware
Semiconductors
Information services
Therapeutic
Internet consumer & business services
Drug delivery
Consumer & business products
Biotechnology tools
Energy
Media/Content/Info
Surgical Devices
Advanced Specialty Materials & Chemicals
Diagnostic
During the three and nine-month periods ended September 30, 2007, the Company made investments in debt securities totaling $35.2 million and $213.0 million, respectively. In addition, during the three and nine-month periods ended September 30, 2007, the Company made investments in equity securities of approximately $3.2 million and $6.0 million, respectively.
Loan origination and commitment fees received in full at the inception of a loan are deferred and amortized into fee income as an enhancement to the related loan’s yield over the contractual life of the loan. Loan exit fees to be paid at the termination of the loan are accreted into fee income over the contractual life of the loan. Original discount fees are reflected as an adjustment to the loan yield. The Company had approximately $5.1 million and $3.5 million of unamortized fees at September 30, 2007 and December 31, 2006, respectively, and approximately $1.9 million and $1.0 million in exit fees receivable at September 30, 2007 and December 31, 2006, respectively.
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While not significant to the total debt investment portfolio, the Company has loans in its portfolio that contain a payment-in-kind (“PIK”) provision. The PIK interest, computed at the contractual rate specified in each loan agreement, is added to the principal balance of the loan and recorded as interest income. To maintain the Company’s status as a RIC, this non-cash source of income must be paid out to stockholders in the form of dividends even though the Company has not yet collected the cash. Amounts necessary to pay these dividends may come from available cash or the liquidation of certain investments. For the three and nine-month periods ended September 30, 2007, approximately $134,000 and $209,000 in PIK income was recorded. There was no PIK income recorded in prior periods.
In some cases, the Company collateralizes its investments by obtaining a first priority security interest in a portfolio companies’ assets, which may include their intellectual property. In other cases, the Company may obtain a negative pledge covering a company’s intellectual property. At September 30, 2007, approximately 29 portfolio company loans were secured by a first priority security in all of the assets of the portfolio company and 41 portfolio company loans were prohibited from pledging or encumbering their intellectual property. See “Part II—Item 1A—Risk Factors.”
3. Borrowings
The Company, through Hercules Funding Trust I, an affiliated statutory trust, executed a securitized credit facility (the “Credit Facility”) with Citigroup Global Markets Realty Corp. (“Citigroup”). On December 6, 2006, the Company amended the Credit Facility with an agreement that increased the borrowing capacity under the facility to $150.0 million. On March 30, 2007, this increase was extended to July 31, 2007, and the interest on all borrowings was reduced to LIBOR plus a spread of 1.20%. On May 2, 2007, the Company amended the Credit Facility to extend the expiration date to May 1, 2008, increased the borrowing capacity under the facility to $250.0 million and included Deutsche Bank Securities Inc. as a participant in the Credit Facility along with Citigroup Markets Realty Corp. The credit facility is a one year facility and is renewable on May 1, 2008 with an interest rate of LIBOR plus a spread of 1.20%. The Company paid a structuring fee of $375,000 which will be expensed ratably through maturity.
The Credit Facility is collateralized by loans from the Company’s portfolio companies, and includes an advance rate of approximately 55% of eligible loans. The Credit Facility contains covenants that, among other things, require the Company to maintain a minimum net worth and to restrict the loans securing the Credit Facility to certain dollar amounts, to concentrations in certain geographic regions and industries, to certain loan grade classifications, to certain security interests, and to certain interest payment terms. Citigroup has an equity participation right through a warrant participation agreement on the pool of loans and warrants collateralized under the Credit Facility. Pursuant to the warrant participation agreement, the Company granted to Citigroup a 10% participation in all warrants held as collateral. However, no additional warrants are included in collateral subsequent to the facility amendment on May 2, 2007. As a result, Citigroup is entitled to 10% of the realized gains on the warrants until the realized gains paid to Citigroup pursuant to the agreement equals $3,750,000 (the “Maximum Participation Limit”). The Obligations under the warrant participation agreement continue even after the Credit Facility is terminated until the Maximum Participation Limit has been reached. During the nine months ended September 30, 2007, the Company recorded an additional liability and reduced its unrealized gains by approximately $214,000 to account for Citigroup’s participation in unrealized gains in the warrant portfolio. The value of their participation right on unrealized gains in the related equity investments since inception of the agreement was approximately $590,000 at September 30, 2007 and is included in accrued liabilities and reduces the unrealized gain recognized by the Company at September 30, 2007. Since inception of the agreement, the Company has paid Citigroup approximately $367,000 under the warrant participation agreement, thereby reducing its realized gains by that amount.
At September 30, 2007, the Company, through its special purpose entity (SPE), had transferred pools of loans and warrants with a fair value of approximately $220.7 million to Hercules Funding Trust I and had drawn $32.2 million under the Credit Facility. Transfers of loans have not met the requirements of Statement of Financial Accounting Standards (“SFAS”) No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, for sales treatment and are, therefore, treated as secured borrowings, with the transferred loans remaining in investments and the related liability recorded in borrowings. The average debt outstanding under the Credit Facility for the three and nine-month periods ended September 30, 2007 was approximately $20.8 and $52.8 million, respectively, and the average interest rates were approximately 6.69% and 6.49% respectively.
In January 2005, the Company formed HT II and HTM. HT II is licensed as a SBIC. HT II borrows funds from the SBA against eligible investments and additional deposits to regulatory capital. Under the Small Business Investment Act and current SBA policy applicable to SBICs, an SBIC can have outstanding at any time SBA guaranteed debentures up to twice the amount of its Regulatory Capital. As of September 30, 2007, the maximum statutory limit on the dollar amount of outstanding SBA guaranteed debentures issued by a single SBIC is $127.2 million, subject to periodic adjustments by the
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SBA. With $63.6 million of Regulatory Capital as of September 30, 2007, HT II has the current capacity to issue up to a total of $127.2 million of SBA guaranteed debentures, subject to the payment of a 1% commitment fee to the SBA on the amount of the commitment. Currently, HT II has paid commitment fees of approximately $1.3 million and has a commitment from the SBA to issue a total of $127.2 million of SBA guaranteed debentures, of which $19.8 million was outstanding as of September 30, 2007. There is no assurance that HT II will draw up to the maximum limit available under the SBIC program.
SBICs are designed to stimulate the flow of private equity capital to eligible small businesses. Under present SBA regulations, eligible small businesses include businesses that have a tangible net worth not exceeding $18 million and have average annual fully taxed net income not exceeding $6 million for the two most recent fiscal years. In addition, SBICs must devote 20% of its investment activity to “smaller” concerns as defined by the SBA. A smaller concern is one that has a tangible net worth not exceeding $6 million and has average annual fully taxed net income not exceeding $2 million for the two most recent fiscal years. SBA regulations also provide alternative size standard criteria to determine eligibility, which depend on the industry in which the business is engaged and are based on such factors as the number of employees and gross sales. According to SBA regulations, SBICs may make long-term loans to small businesses, invest in the equity securities of such businesses and provide them with consulting and advisory services. Through our wholly-owned subsidiary HT II, the Company plans to provide long-term loans to qualifying small businesses, and in connection therewith, make equity investments.
HT II is periodically examined and audited by the SBA’s staff to determine its compliance with SBIC regulations. As of September 30, 2007, HT II could draw up to $127.2 million of leverage from the SBA. On April 26, 2007, HT II drew down its first borrowing of $12.0 million under the program and drew an additional $7.8 million on September 26, 2007. Borrowings under the program are charged interest based on ten year treasury rates plus a spread and the rates are generally set for a pool of debentures issued by the SBA in six month periods. The rate for the borrowing originated from March 13, 2007 to September 10, 2007 was set by the SBA as announced on September 26, 2007 at 5.528%. The rate for borrowings made after September 10, 2007 through March 13, 2008 are based on LIBOR plus a spread of 0.30% until the next interest rate set by the SBA occurs. In addition, the SBA charges an annual fee that is set annually, depending on the Federal fiscal year the leverage commitment was delegated by the SBA, regardless of the date that the leverage was drawn by the SBIC. The current annual fee is set at 0.906%. Interest payments are payable semi-annually and there are no principal payments required on these issues prior to maturity.
At September 30, 2007 and December 31, 2006, the Company had the following borrowing capacity and outstandings:
Credit Facility
SBA Debenture
Total
4. Income taxes
The Company intends to continue to operate so as to qualify to be taxed as a RIC under the Code and, as such, the Company is not subject to federal income tax on the portion of its taxable income and gains distributed to stockholders. To qualify as a RIC, the Company is required, among other requirements, to distribute at least 90% of its annual investment company taxable income, as defined by the Code. The amount to be paid out as a dividend is determined by the Board of Directors each quarter and is based upon the annual earnings estimated by the management of the Company. To the extent that the Company’s earnings fall below the amount of dividends declared, however, a portion of the total amount of the Company’s dividends for the fiscal year may be deemed a return of capital for tax purposes to the Company’s stockholders. On September 17, 2007, the Company paid a dividend of $0.30 per share.
For the fiscal year ended December 31, 2006, 11.5% of the distributions to the Company’s shareholders was deemed a return of capital. For the quarter ended September 30, 2007, the Company declared a distribution of $0.30 per share. The determination of the tax attributes of the Company’s distributions is made annually as of the end of the Company’s fiscal year based upon its taxable income for the full year and distributions paid for the full year, therefore a determination made on a quarterly basis may not be representative of the actual tax attributes of its distributions for a full year. If the Company determined the tax attributes of its distributions year-to-date as of September 30, 2007, approximately $0.88 or 98.1% would be from ordinary income and approximately $0.02 or 1.9% would be a return of capital for stockholders, however there can be no certainty to shareholders that this determination is representative of what the tax attributes of its 2007 distributions to shareholders will actually be.
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At March 31, 2006, as a C corporation, the Company had a deferred tax asset of approximately $181,000. During the second quarter of 2006, a full valuation reserve was recorded against this asset in anticipation that the Company would not have a future federal tax expense to offset the deferred tax asset. In addition, during the first quarter of 2006, the Company recorded a tax expense in the amount of approximately $1.8 million that was reversed in the second quarter as the Company was not subject to federal income or excise taxes in 2006. As a result, the Company recorded a tax benefit of approximately $800,000 in the second quarter of 2006.
In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109”, which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. As required, we adopted FIN 48 as of January 1, 2007. We conducted a review of all open tax year’s income recognition and expense deduction filing positions and income tax returns filed (federal and state) for determination of any uncertain tax positions that may require recognition of a tax liability. This review encompassed an analysis of all book/tax difference adjustments as well as the timing of income and expense recognition for all tax years still open under the statute of limitations. As a result, we determined that it is more likely than not that each tax position taken on a previously filed return or to be taken on current tax returns will be sustained on examination based on the technical merits of the positions and therefore, no recognition of a tax liability on an uncertain tax position for FIN 48 purposes is anticipated.
5. Stockholders’ Equity
The Company is authorized to issue 60,000,000 shares of common stock with a par value of $0.001. Each share of common stock entitles the holder to one vote.
In January 2005, the Company notified its shareholders of its intent to elect to be regulated as a BDC. In conjunction with the Company’s decision to elect to be regulated as a BDC, approximately 55% of the 5 Year Warrants were subject to mandatory cancellation under the terms of the Warrant Agreement with the warrant holder receiving one share of common stock for every two warrants cancelled and the exercise price of all warrants was adjusted to the then current net asset value of the common stock, subject to certain adjustments described in the Warrant Agreement. In addition, the 1 Year Warrants became subject to expiration immediately prior to the Company’s election to become a BDC, unless exercised. Concurrent with the announcement of the BDC election, the Company reduced the exercise price of all remaining 1 and 5 Year Warrants from $15.00 to $10.57. On February 22, 2005, the Company cancelled 47% of all outstanding 5 Year Warrants and issued 298,598 shares of common stock to holders of warrants upon exercise. In addition, the majority of shareholders owning 1 Year Warrants exercised them, and purchased 1,175,963 of common shares at $10.57 per share, for total consideration to the Company of approximately $12.4 million. All unexercised 1 Year Warrants were then cancelled. The outstanding 5 Year Warrants will expire in June 2009.
A summary of activity in the 5 Year Warrants initially attached to units issued for the nine months ended September 30, 2007 is as follows:
Five-Year
Warrants
Warrants outstanding at December 31, 2006
Warrants issued
Warrants cancelled
Warrants exercised
Warrants outstanding at September 30, 2007
The Company received net proceeds of approximately $3.1 million from the exercise of the 5-Year Warrants in the period ended September 30, 2007.
On October 20, 2006, the Company raised approximately $30.0 million, net of estimated issuance costs, in a public offering of 2.5 million shares of its common stock.
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On December 12, 2006, the Company raised approximately $74.1 million, net of estimated issuance costs, in a public offering of 5.7 million shares of its common stock.
On January 3, 2007, in connection with the December 12, 2006 common stock issuance, the underwriters exercised their over-allotment option and purchased an additional 840,000 shares of common stock for additional net proceeds of approximately $10.9 million.
On June 4, 2007, the Company raised approximately $102.2 million, net of issuance costs, in a public offering of 8.0 million shares of its common stock. On June 19, 2007, in connection with the same common stock issuance, the underwriters exercised their over-allotment option and purchased an additional 1.2 million shares of common stock for additional net proceeds of approximately $15.4 million.
6. Earnings per Share
Shares used in the computation of the Company’s basic and diluted earnings per share are as follows:
Weighted average common shares outstanding
Change in net assets per common share - basic
Dilutive effect of warrants and stock options
Weighted average common shares outstanding, assuming dilution
Change in net assets per common share - assuming dilution
The calculation of change in net assets per common share - assuming dilution, excludes all anti-dilutive shares. For the three months ended September 30, 2007 and 2006, the number of anti-dilutive shares, as calculated based on the weighted average closing price of our common stock for the periods, was approximately 2,142,000 and 1,858,000 shares, respectively. For the nine months ended September 30, 2007 and 2006, the number of anti-dilutive shares, as calculated based on the weighted average closing price of our common stock for the periods, was approximately 1,066,000 and 1,858,000 shares, respectively.
7. Related-Party Transactions
In conjunction with the Company’s public offering completed on December 7, 2006, the Company agreed to pay JMP Securities LLC a fee of approximately $1.2 million as co-manager of the offering. In conjunction with the over-allotment exercise completed in January 2007, the Company paid JMP Securities a fee of approximately $171,000.
During February 2007, Farallon Capital Management, L.L.C and its related affiliates and Manuel Henriquez, the Company’s CEO, exercised warrants to purchase 132,480 and 75,075 shares of the Company’s common stock, respectively. The exercise price of the warrants was $10.57 per share resulting in net proceeds to the company of approximately $2.2 million.
In conjunction with the Company’s public offering completed on June 4, 2007 and the related over-allotment exercise, the Company agreed to pay JMP Securities LLC a fee of approximately $1.6 million as co-manager of the offering.
8. Equity Incentive Plan
The Company and its stockholders have authorized and adopted an equity incentive plan (the “2004 Plan”) for purposes of attracting and retaining the services of its executive officers and key employees. Under the 2004 Plan, the Company is authorized to issue 7,000,000 shares of common stock. Unless terminated earlier by the Company’s Board of Directors, the 2004 Plan will terminate on June 9, 2014, and no additional awards may be made under the 2004 Plan after that date.
The Company and its stockholders have authorized and adopted the 2006 Non-Employee Director Plan (the “2006 Plan”) for purposes of attracting and retaining the services of its Board of Directors. Under the 2006 Plan, the Company is authorized to issue 1,000,000 shares of common stock. Unless terminated earlier by the Company’s Board of Directors, the 2006 Plan will terminate on May 29, 2016 and no additional awards may be made under the 2006 Plan after that date. The Company filed an exemptive relief request with the Securities and Exchange Commission (“SEC”) to allow options to be issued under the 2006 Plan which was approved on February 15, 2007.
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On June 21, 2007, the shareholders approved amendments to the 2004 Plan and the 2006 Plan allowing for the grant of restricted stock. The amended Plans limit the combined maximum amount of restricted stock that may be issued under both Plans to 10% of the outstanding shares of our stock on the effective date of the Plans plus 10% of the number of shares of stock issued or delivered by Hercules during the terms of the Plans. The proposed amendments further specify that no one person shall be granted awards of restricted stock relating to more than 25% of the shares available for issuance under the 2004 Plan. Further, the amount of voting securities that would result from the exercise of all our outstanding warrants, options and rights, together with any restricted stock issued pursuant to the Plans, at the time of issuance shall not exceed 25% of our outstanding voting securities, except that if the amount of voting securities that would result from such exercise of all of our outstanding warrants, options and rights issued to Hercules directors, officers and employees, together with any restricted stock issued pursuant to the Plans, would exceed 15% of our outstanding voting securities, then the total amount of voting securities that would result from the exercise of all outstanding warrants, options and rights, together with any restricted stock issued pursuant to the Plans, at the time of issuance shall not exceed 20% of our outstanding voting securities.
In conjunction with the amendment and in accordance with the exemptive order, on June 21, 2007 the Company made an automatic grant of shares of restricted common stock to Messrs. Badavas, Chow and Woodward, its independent Board of Directors, in the amounts of 1,667, 1,667 and 3,334 shares, respectively. The shares were issued pursuant to the 2006 Plan on July 31, 2007 and vest 33% on an annual basis from the date of grant. Deferred compensation cost of approximately $90,000 will be recognized ratably over the three year vesting period.
In 2004, each employee stock option to purchase two shares of common stock was accompanied by a warrant to purchase one share of common stock within one year and a warrant to purchase one share of common stock within five years.
Both options and warrants had an exercise price of $15.00 per share on date of grant. On January 14, 2005, the Company notified all shareholders of its intent to elect to be regulated as a BDC and reduced the exercise price of all remaining 1 and 5 Year Warrants from $15.00 to $10.57 but did not reduce the strike price of the options (see Note 5). The unexercised one-year warrants expired and 55% of the five-year warrants were cancelled immediately prior to the Company’s election to become a BDC.
A summary of common stock options and warrant activity under the Company’s 2004 Plan for the nine months ended September 30 is as follows:
Outstanding at December 31, 2006
Granted
Exercised
Cancelled
Outstanding at September 30, 2007
Weighted-average exercise price at September 30, 2007
Options generally vest 33% one year after the date of grant and ratably over the succeeding 24 months. All options may be exercised for a period ending seven years after the date of grant. At September 30, 2007 options for approximately 1.3 million shares were exercisable at a weighted average exercise price of approximately $13.15 per share with a weighted average exercise term of 4.5 years. The outstanding five year warrants have an expected life of five years.
The Company determined that the fair value of options granted during the nine month periods ended September 30, 2007 and 2006 was approximately $1.4 million and approximately $817,000, respectively. During the nine month periods ended September 30, 2007 and 2006, approximately $842,000 and $429,000 of share-based cost was expensed, respectively. As of September 30, 2007, there was $1.7 million of total unrecognized compensation costs related to stock options. These costs are expected to be recognized over a weighted average period of 2.0 years. The fair value of options granted in 2007 and 2006 was based upon a Black-Scholes option pricing model using the assumptions in the following table for each of the nine month periods ended September 30, 2007:
Expected Volatility
Expected Dividends
Expected term (in years)
Risk-free rate
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9. Financial Highlights
Following is a schedule of financial highlights for the nine months ended September 30, 2007 and 2006:
Per share data:
Net asset value at beginning of period
Net realized gain on investments
Total from investment operations
Net increase/(decrease) in net assets from capital share transactions
Stock-based compensation expense included in investment income (1)
Net asset value at end of period
Ratios and supplemental data:
Per share market value at end of period
Total return (2)
Shares outstanding at end of period
Weighted average number of common shares outstanding
Net assets at end of period
Ratio of operating expense to average net assets (annualized)
Ratio of net investment income before provision for income tax expense and investment gains and losses to average net assets (annualized)
Average debt outstanding
Weighted average debt per common share
Portfolio turnover
10. Commitments and Contingencies
In the normal course of business, the Company is party to financial instruments with off-balance sheet risk. These instruments consist primarily of unused commitments to extend credit, in the form of loans, to the Company’s portfolio companies. The balance of unused commitments to extend credit at September 30, 2007 totaled approximately $107.7 million. Since this commitment may expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements.
Certain premises are leased under agreements which expire at various dates through December 2013. Total rent expense amounted to approximately $552,000 and $198,000 during the nine-month periods ended September 30, 2007 and 2006, respectively.
The following table shows our contractual obligations as of September 30, 2007:
Contractual Obligations(1)
Borrowings (4)
Operating Lease Obligations
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The Company and its executives and directors are covered by Directors and Officers Insurance, with the directors and officers being indemnified by the Company to the maximum extent permitted by Maryland law subject to the restrictions in the 1940 Act.
11. Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157 (“FAS 157”), “Fair Value Measurements.” Among other requirements, FAS 157 defines fair value and establishes a framework for measuring fair value and also expands disclosure about the use of fair value to measure assets and liabilities. FAS 157 is effective for the first fiscal year that begins after November 15, 2007. The Company is currently evaluating the impact of FAS 157 on its financial position and results of operations. As of September 30, 2007, the Company does not believe the adoption of FAS 157 will impact the amounts reported in the financial statements, however, additional disclosures will be required about the inputs used to develop the measurements of fair value and the effect of certain of the measurements reported in the statement of operations for a fiscal period.
12. Subsequent Events
On October 10, 2007, the SEC granted exemptive relief permitting the Company to issue stock options to its non-employee directors pursuant to the 2006 Non-Employee Director Plan. Pursuant to the order, Messrs. Badavas and Chow were automatically granted 5,000 options each, and Mr. Woodward was automatically granted 10,000 options. All options were granted at the closing stock price of $13.40 on October 10, 2007 and vest 33% one year after the date of grant and ratably over the succeeding 24 months.
On November 1, 2007, the Board of Directors declared a dividend of $0.30 per share for the third quarter, payable on December 17, 2007 to shareholders of record as of November 16, 2007.
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Forward-Looking Statements
The information set forth in this report includes “forward-looking statements.” Such statements may include, but are not limited to: projections of revenues, income or loss, capital expenditures, plans for product development and cooperative arrangements, future operations, financing needs, or plans of Hercules, as well as assumptions relating to the foregoing. The terms “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential,” or “continue,” or the negatives of these terms, or other similar expressions generally identify forward-looking statements.
The forward-looking statements made in this Form 10-Q speak only to events as of the date on which the statements are made. You should not place undue reliance on such forward-looking statements, as substantial risks and uncertainties could cause actual results to differ materially from those projected in or implied by these forward-looking statements due to a number of risks and uncertainties affecting its business. The forward-looking statements contained in this Form 10-Q are made as of the date hereof, and Hercules assumes no obligation to update the forward-looking statements for subsequent events.
Overview
We are a specialty finance company that provides debt and equity growth capital to technology-related companies at all stages of development from seed and emerging growth to expansion and established development. We primarily finance privately-held companies backed by leading venture capital and private equity firms and also may finance certain publicly-traded companies and lower middle market companies. We source our investments through our principal office located in Silicon Valley, as well as our additional offices in the Boston, Boulder, Chicago, Costa Mesa and Columbus areas. Additionally, we are expanding our Southern California presence, with the addition of two highly experienced technology equity venture investors and one PhD to our life sciences team during the quarter ended September 30, 2007. Our goal is to be the leading structured mezzanine capital provider of choice for venture capital and private equity backed technology-related and life science companies requiring sophisticated and customized financing solutions. Our strategy is to evaluate and invest in a broad range of companies active in the technology and life science industries and to offer a full suite of growth capital products up and down the capital structure. We invest primarily in structured mezzanine debt and, to a lesser extent, in senior debt and equity investments. We use the term “structured mezzanine debt investment” to refer to any debt investment, such as a senior or subordinated secured loan, that is coupled with an equity component, including warrants, options or rights to purchase common or preferred stock. Our structured mezzanine debt investments will typically be secured by some or all of the assets of the portfolio company.
Our investment objective is to maximize our portfolio’s total return by generating current income from our debt investments and capital appreciation from our equity-related investments. We are an internally managed, non-diversified closed-end investment company that has elected to be regulated as a business development company under the 1940 Act. As a business development company, we are required to comply with certain regulatory requirements. For instance, we generally have to invest at least 70% of our total assets in “qualifying assets,” including securities of private U.S. companies, cash, cash equivalents, U.S. government securities and high-quality debt investments that mature in one year of less.
We may engage in the asset management business by providing investment advisory services to externally managed funds that may be formed in the future. We may, from time to time, serve as the investment manager of such funds and may receive management and other fees for such services. Such funds may have overlapping investment objectives and may invest in asset classes similar to those targeted by us.
Portfolio and Investment Activity
The total value of our investment portfolio was $415.6 million at September 30, 2007 as compared to $283.2 million at December 31, 2006. We have had low originations for the quarter ended September 30, 2007 as a result of seasonal slowdown, which we have experienced in the past. We expect originations and fundings to increase during the fourth quarter of 2007, as evidenced by our unfunded commitments and pending commitments of approximately $107.7 million and $133.0 million, respectively, as of September 30, 2007. During the three and nine-month periods ended September 30, 2007, we made debt commitments to eight and 37 portfolio companies totaling $40.2 million and $289.8, respectively. We funded debt investments of $35.2 million to 22 companies and $213.0 million to 61 companies during the three and nine-month periods ended September 30, 2007, respectively. During the three and nine-month periods ended September 30, 2007, we also received normal principal repayments of approximately $18.3 million and $46.1 million, and early repayments and recoveries of $16.3 million and $29.8 million from four and 11 companies, respectively. We also received pay downs of $2.0 and $11.1 million on working capital lines of credit for the three and nine-month periods ended September 30, 2007. We also made equity investments in four and ten portfolio companies totaling $3.3 million and $6.1 million during the three and nine-month periods ended September 30, 2007, respectively. At September 30, 2007, our equity investments have a fair value of approximately $15.6 million. At September 30, 2007, we had unfunded contractual commitments of $107.7 million to 28 portfolio companies. In addition, as of September 30, 2007, we executed non-binding term sheets with nine prospective portfolio companies, representing approximately $133.0 million. These proposed investments are subject to completion of our due diligence and final approval process, as well as the negotiation of definitive documentation with the prospective portfolio companies. Not all non-binding term sheets are expected to close and do not necessarily represent future cash requirements.
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Total portfolio investment activity (exclusive of unearned income) as of and for the period ended September 30, 2007 was as follows:
September 30,
2007
Beginning Portfolio
Equity Investments
Early pay-offs and recoveries
Net realized and unrealized change in investments
Ending Portfolio
The following table shows the fair value of our portfolio of investments by asset class as of September 30, 2007 and December 31, 2006 (excluding unearned income):
A Summary of the company’s investment portfolio at value by geographic location is as follows:
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We use an investment grading system, which grades each debt investment on a scale of 1 to 5, to characterize and monitor our expected level of risk on the debt investments in our portfolio with 1 being the highest quality. The following table shows the distribution of our outstanding debt investments on the 1 to 5 investment grading scale at fair value as of September 30, 2007 and December 31, 2006:
Investment Grading
1
2
As of September 30, 2007, our investments had a weighted average investment grading of 2.20 as compared to 2.14 at December 31, 2006. Our policy is to reduce the grading on our portfolio companies as they approach the point in time when they will require additional equity capital. Additionally, we may downgrade our portfolio companies if they are not meeting our financing criteria and their respective business plans. Various companies in our portfolio will require additional funding in the near term or have not met their business plans and have therefore been downgraded until the funding is complete or their operations improve.
The effective yield on our debt investments during the quarter was 15.6% and was attributed in part to higher interest charges and fees related to loan restructurings and acceleration of fee income recognition from early loan repayments. The overall weighted average yield to maturity of our loan obligations was approximately 12.79% as September 30, 2007. The weighted average yield to maturity is computed using the interest rates in effect at the inception of each of the loans, and includes amortization of the loan facility fees, commitment fees and market premiums or discounts over the expected life of the debt investments, weighted by their respective costs when averaged and based on the assumption that all contractual loan commitments have been fully funded and held to maturity.
We generate revenue in the form of interest income, primarily from our investments in debt securities, and commitment and facility fees. Fees generated in connection with our debt investments are recognized over the life of the loan or, in some cases, recognized as earned. In addition, we generate revenue in the form of capital gains, if any, on warrants or other equity-related securities that we acquire from our portfolio companies. Our investments generally range from $1.0 million to $25.0 million, with an average initial principal balance of between $3.0 million and $7.0 million. Our debt investments have a term
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of between two and seven years and typically bear interest at a rate ranging from 8.0% to 14.0% (based on current interest rate conditions). In addition to the cash yields received on our loans, in some instances, our loans may also include any of the following: end-of-term payments, PIK interest exit fees, balloon payment fees, prepayment fees, and diligence fees, which may be required to be included in income prior to receipt. In some cases, we collateralize our investments by obtaining security interests in our portfolio companies’ assets, which may include their intellectual property. In other cases, we may obtain a negative pledge covering a company’s intellectual property. See “Part II—Item 1A—Risk Factors.” At September 30, 2007, approximately 29 portfolio company loans were secured by a first priority security in all of the assets of the portfolio company and 41 portfolio company loans were prohibited from pledging or encumbering their intellectual property. Interest on debt securities is generally payable monthly, with amortization of principal typically occurring over the term of the security for emerging-growth and expansion-stage companies. In addition, certain loans may include an interest-only period ranging from three to twelve months. In limited instances in which we choose to defer amortization of the loan for a period of time from the date of the initial investment, the principal amount of the debt securities and any accrued but unpaid interest become due at the maturity date. Our mezzanine debt investments also generally have equity enhancement features, typically in the form of warrants or other equity-related securities designed to provide us with an opportunity for capital appreciation.
As of September 30, 2007, we have received warrants in connection with our debt investments in each portfolio company, and have realized gains on seven warrant positions. We currently hold warrants in 75 portfolio companies, with a fair value of approximately $13.2 million included in the investment portfolio of $415.6 million. The fair value of the warrant portfolio has increased by 44.0% to $13.2 million as compared to the fair value of $9.2 million at September 30, 2006. These warrant holdings would allow us to invest approximately $43.7 million if such warrants are exercised.
Results of Operations
Comparison of the Three and Nine-Month Periods Ended September 30, 2007 and 2006
Operating Income
Interest income totaled approximately $13.6 and $34.4 million for the three and nine-month periods ended September 30, 2007, respectively, compared with $6.7 and $18.5 for the three and nine-month periods ended September 30, 2006. Income from commitment, facility and one time fees totaled approximately $1.6 and $3.7 million for the three and nine-month periods ended September 30, 2007, respectively, as compared with approximately $847,000 and $2.3 million for the three and nine-month periods ended September 30, 2006. The increases in investment income and income from commitment, facility and one time fees for both periods presented are the result of higher average loan balances outstanding due to origination activity and yield from the related investments.
At September 30, 2007, we had approximately $5.1 million of deferred revenue related to commitment and facility fees, as compared to approximately $3.6 million as of September 30, 2006. We expect to generate additional interest income and loan fees as we continue to originate additional investments.
Operating Expenses
Operating expenses totaled approximately $5.1 million and $15.6 million during the three and nine-month periods ended September 30, 2007, respectively, compared with $4.4 and $13.2 million during the three and nine-month periods ended September 30, 2006, respectively. Operating expenses for the three and nine-month periods ended September 30, 2007 included interest expense, loan fees and unused commitment fees of approximately $972,000 and $3.9 million, respectively, compared with $1.6 and $5.1 million for the three and nine-month periods ended September 30, 2006, respectively. The 38.1% decrease in interest expense and loan fees was due to the lower average debt outstanding of approximately $33.2 million during the three months ended September 30, 2007 as compared to $71.1 million during the same period in 2006. The expense was lower for the nine month period of 2007 compared to 2006 due to a lower average debt balance and lower average interest rate. The weighted average cost of debt was approximately 6.5% at September 30, 2007. Employee compensation and benefits were approximately $2.4 and $6.4 million during the three and nine-month periods ended September 30, 2007, respectively, compared with $1.2 and $3.6 million during the three and nine-month periods ended September 30, 2006, respectively. The increase in compensation expense was directly related to increasing our number of employees from 23 employees at September 30, 2006 to 39 employees at September 30, 2007. General and administrative expenses were $1.4 and $4.4 million for the three and nine-month periods ended September 30, 2007, steady with $1.4 million during the three-month period ended September 30, 2006 and up from $4.0 million during the nine-month period ended September 30, 2006. The overall increase was primarily due to increased legal expense related to workouts in two portfolio companies, professional service costs related to our status as a public company and the creation of our SBIC subsidiaries as well as increased business development expenses. We also incurred approximately $295,000 and $842,000 of stock-based compensation expense during the three and nine-month periods ended September 30, 2007, as compared to $176,000 and $429,000 in 2006, respectively. In addition, we incurred approximately $5,000 in restricted stock expense during the three and nine-month periods ended September 30, 2007. There were no restricted stock expenses during the three and nine-month periods ended September 30, 2006.
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Net Investment Income Before Income Tax Expense and Investment Gains and Losses
Net investment income before provision for income tax expense for the three and nine-month periods ended September 30, 2007 totaled $10.0 and $22.5 million, respectively, as compared with net investment income before provision for income tax expense of approximately $3.1 and $7.6 million for the three and nine-month periods ended September 30, 2006. The changes are made up of the items described above under “Operating Income” and “Operating Expenses.”
Net Investment Gains/Losses
Realized gains or losses are measured by the difference between the net proceeds from the repayment or sale and the cost basis of the investment without regard to unrealized appreciation or depreciation previously recognized, and include investments charged off during the period, net of recoveries. Net change in unrealized appreciation or depreciation primarily reflects the change in portfolio investment values during the reporting period, including the reversal of previously recorded unrealized appreciation or depreciation when gains or losses are realized.
During the three month period ended September 30, 2007, we generated a net realized gain totaling approximately $49,000 due to the gains of approximately $433,000 on the sale of common stock in two portfolio companies offset by the unrealized loss of two warrants with a cost basis of approximately $384,000 based on the Black-Scholes value at the time of the loan origination. This realized loss was the reversal of an unrealized loss recorded in the previous quarters of 2007. This brings the total net realized gains to approximately $3,000 for the nine month period ended September 30. 2007. During the three month period ended September 30, 2006, we generated a net realized loss totaling approximately $2.6 million due primarily from the sale of one portfolio company. During the nine month period ended September 30, 2006, we generated a net realized loss totaling approximately $2.6 million due primarily to the loss on two portfolio companies of $5.7 million offset by the sale of equity and warrants in two portfolio companies totaling approximately $1.4 million as well as the recovery of approximately $1.7 million on one portfolio company.
For the three and nine-month periods ended September 30, 2007, net unrealized investment depreciation totaled approximately $2.9 and $733,000 respectively, compared to net unrealized appreciation of approximately $593,000 and $3.0 million for the three and nine-month period ended September 30, 2006. The net unrealized appreciation and depreciation of investments is based on portfolio asset valuations determined in good faith by our Board of Directors. At September 30, 2007, gross unrealized appreciation totaled approximately $8.8 million in 27 of our portfolio investment companies and approximately $6.2 million of gross unrealized depreciation on 49 of our portfolio investment companies. At September 30, 2006, gross unrealized appreciation totaled approximately $5.7 million in 16 of our portfolio investment companies and approximately $1.8 million of gross unrealized depreciation on 35 of our portfolio investment companies. The net unrealized depreciation totaling approximately $2.9 million for the three month period ended September 30, 2007 was the result of an unrealized loss of $2.0 million of one portfolio company, a net unrealized loss of approximately $1.2 million in the value of our public company warrants, offset by a net unrealized gain of approximately $300,000 in the value of our private company equity and warrant portfolio. The net decrease in unrealized appreciation totaling approximately $593,000 for the three-months ended September 30, 2006 was primarily the result of an increase in value of a debt conversion right in one investment of approximately $287,000 and the net unrealized gain in our warrant and equity portfolio of approximately $306,000.
We anticipate ten to twelve liquidity events from our portfolio companies in the current fiscal year. During the first nine months of 2007 we have had three portfolio companies acquired, one completed its IPO, four portfolio companies filed registration statements for IPOs of which one was subsequently withdrawn, and four other portfolio companies are in various stages of M&A discussions.
During the third quarter, two portfolio companies, Sling Media and Interwise, announced they were being acquired and we recognized approximately $1.3 million of unrealized gains from our warrant and equity investments in these companies. The total unrealized gains recognized to date on investments in these two portfolio companies is approximately $2.6 million based on the estimated fair value as of September 30, 2007.
Income Taxes
We account for income taxes in accordance with the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, which requires that deferred income taxes be determined based upon the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities given the provisions of the enacted tax law. Valuation allowances are used to reduce deferred tax assets to the amount likely to be realized.
We elected to be treated as a RIC under Subchapter M of the Code for 2006 with the submission of our 2006 tax return. Such election and qualification to be treated as a RIC requires that we comply with certain requirements contained in Subchapter M of the Code. For example, a RIC must meet certain requirements, including source-of-income, asset diversification and income distribution requirements. The income source requirement mandates that we receive 90% or more of our income from qualified earnings, typically referred to as “good income.” Qualified earnings may exclude such income as management fees received in connection with our SBIC or other potential outside managed funds and certain other fees.
We reported our financial position and results of operations under Subchapter C of the Code prior to 2006. As a C corporation, we accrued income tax expense on a quarterly basis until we were able to reasonably determine that we qualified as a RIC under requirements contained in Subchapter M of the Code. During 2006, we were able to reasonably determine that we could qualify as a RIC, and we accordingly reversed the income tax expense recorded during 2006 and adjusted through operations the $1.4 million deferred tax asset on our balance sheet at December 31, 2005. If we had been able to make the determination as of December 31, 2005, the impact of charging the deferred tax to operations would have reduced our NAV by approximately $0.15 per share.
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Net Increase in Net Assets Resulting from Operations and Earnings Per Share
For the three and nine-month periods ended September 30, 2007, net income totaled approximately $7.2 and $21.8 million, respectively, compared to net income of approximately $1.6 and $7.4 million for the three and nine-month periods ended September 30, 2006. These changes are made up of the items previously described.
Basic and fully diluted net income per share for the three and nine-month periods ended September 30, 2007 was $0.22 and $0.81 per share, respectively, as compared to a basic net income per share of $0.12 and $0.61, and fully diluted net income per share of $0.11 and $0.61 for the three and nine-month periods ended September 30, 2006, respectively.
Financial Condition, Liquidity, and Capital Resources
During the nine-month period ended September 30, 2007, we received net proceeds of approximately $3.1 million from the exercise of the 5-Year Warrants.
On October 20, 2006, we raised approximately $30.0 million, net of estimated issuance costs, in a public offering of 2.5 million shares of common stock delivered on October 25, 2006.
On December 12, 2006, we raised approximately $74.1 million, net of estimated issuance costs, in a public offering of 5.7 million shares of common stock. On January 3, 2007, in connection with the same common stock issuance, the underwriters exercised their over-allotment option and purchased an additional 840,000 shares of common stock for additional net proceeds to the company of approximately $10.9 million.
On June 4, 2007, we raised approximately $102.2 million, net of estimated issuance costs, in a public offering of 8.0 million shares of common stock. On June 19, 2007, in connection with the same common stock issuance, the underwriters exercised their over-allotment option and purchased an additional 1.2 million shares of common stock for additional net proceeds of approximately $15.4 million.
For the nine months ended September 30, 2007, net cash used in operating activities totaled approximately $108.7 million as compared to approximately $51.5 million for the nine months ended September 30, 2006. This increase was due primarily due to approximately $219.3 million used for investment in our portfolio companies offset by $86.6 million of principal payments made during the nine-months ended September 30, 2007 as compared $133.0 million used for investment in our portfolio companies offset by approximately $70.8 million in principal repayments during the nine months ended September 30, 2006. Cash used in investing activities totaled approximately $1.5 million for the nine months ended September 30, 2007 compared with approximately $696,000 for the nine months ended September 30, 2006. This change is primarily the result of an increase in other long-term assets. Net cash provided by financing activities totaled approximately $120.1 million for the nine months ended September 30, 2007 compared to approximately $43.9 million for the nine months ended September 30, 2006. This change is due to net proceeds from the sale of additional common stock of approximately $131.5 million, borrowings of approximately $148.3 million on the credit facilities offset by repayment of approximately $137.3 million and dividends paid of approximately $20.2 million in the nine months ended September 30, 2007.
As of September 30, 2007, net assets totaled approximately $389.6 million, with a net asset value per share of $11.97. We intend to generate additional cash primarily from future borrowings as well as cash flows from operations, including income earned from investment in our portfolio companies and, to a lesser extent, from the temporary investment of cash in U.S. government securities and other high-quality debt investments that mature in one year or less, principal payments from our investments and equity capital. Our primary use of funds will be for operations, investments in portfolio companies and cash distributions to holders of our common stock. After we have used our current capital resources, we expect to raise additional capital to support our future growth through future equity offerings, issuances of senior securities and/or future borrowings, to the extent permitted by the 1940 Act. As a result of the exemptive relief we received related to our SBA debt, we are able to exceed the 1:1 leverage ratio required by the 1940 Act. In order to fully leverage the Company, we would need to obtain additional credit. There can be no assurances that we will seek to, or be successful in, leveraging the Company further.
As required by the 1940 Act, our asset coverage must be at least 200% after each issuance of senior securities. Our asset coverage as of September 30, 2007 was approximately 1,371%, well in excess of the asset coverage requirement.
At September 30, 2007, we had approximately $26.2 million in cash and cash equivalents and available borrowing capacity of approximately $217.8 million under our Credit Facility, subject to existing terms and advance rates and approximately $107.5 million available under the SBA program. We primarily invest cash on hand in interest bearing deposit accounts.
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We anticipate that we will continue to fund our investment activities through a combination of debt and additional equity capital over the next year. As of September 30, 2007, we had approximately $32.2 million outstanding under the Credit Facility and approximately $19.8 million under the SBA program. Through March 30, 2007, advances under the Credit Facility carried interest at one-month LIBOR plus 165 basis points. On March 30, 2007, the interest on all borrowings was reduced to LIBOR plus a spread of 1.20%. On May 2, 2007, we amended the Credit Facility to extend the expiration date to May 1, 2008, increased the borrowing capacity under the facility to $250 million and included Deutsche Bank Securities Inc. as a participant along with Citigroup Markets Realty Corp. The credit facility is a one year facility and is renewable on May 1, 2008 with an interest rate of LIBOR plus a spread of 1.20%. We paid a structuring fee of $375,000 which will be expensed ratably through maturity. As of September 30, 2007, based on $220.7 million of eligible loans in the collateral pool and existing advance rates, we have access to approximately $86.9 million of borrowing capacity available under our $250.0 million securitized credit facility. In addition, Citigroup has an equity participation right of 10% of the realized gains on warrants collateralized under the Credit Facility. However, no additional warrants are included in collateral subsequent to the facility amendment on May 2, 2007. See Note 3 to the Consolidated Financial Statements for discussion of the participation right. We anticipate that portfolio fundings entered into in succeeding periods will allow us to utilize the full borrowing capacity of the Credit Facility.
At September 30, 2007 and December 31, 2006, we had the following borrowing capacity and outstandings:
HT II operates as a Small Business Investment Company under the SBIC program and borrows funds from the SBA against eligible previously approved investments and additional contributions to regulatory capital. As of September 30, 2007, HT II could draw up to $127.2 million of leverage. We made our first draw from the SBA on April 26, 2007 for $12.0 million and a subsequent draw of $7.8 million on September 26, 2007. At September 30, 2007, we had a net investment of $63.6 million in HT II, and there are 21 outstanding investments with a fair value of $77.3 million. On July 31, 2007, we received approval from the SBA to increase our leverage by approximately $77.0 million to a total of $127.2 million, subject to certain regulatory requirements.
Off Balance Sheet Arrangements
In the normal course of business, we are party to financial instruments with off-balance sheet risk. These consist primarily of unfunded commitments to extend credit, in the form of loans, to our portfolio companies. Unfunded commitments to provide funds to portfolio companies will not be reflected on our balance sheet. Our unfunded commitments may be significant from time to time. As of September 30, 2007, we had unfunded commitments of approximately $107.7 million. These commitments will be subject to the same underwriting and ongoing portfolio maintenance as are the on-balance sheet financial instruments that we hold. Since these commitments may expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements.
Contractual Obligations
Payments due by period
(dollars in thousands)
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Borrowings
We, through Hercules Funding Trust I, an affiliated statutory trust, executed a securitized credit facility (the “Credit Facility”) with Citigroup Global Markets Realty Corp. (“Citigroup”). On December 6, 2006, we amended the Credit Facility with an agreement that increased the borrowing capacity under the facility to $150.0 million. On March 30, 2007, this increase was extended to July 31, 2007, and the interest on all borrowings was reduced to LIBOR plus a spread of 1.20%. On May 2, 2007, we amended the Credit Facility to extend the expiration date to May 1, 2008, increased the borrowing capacity under the facility to $250 million and included Deutsche Bank Securities Inc. as a participant in the Credit Facility along with Citigroup Markets Realty Corp. The credit facility is a one year facility and is renewable on May 1, 2008 with an interest rate of LIBOR plus a spread of 1.20%. We paid a structuring fee of $375,000 which will be expensed ratably through maturity. At September 30, 2007, we had $32.2 million outstanding under the Credit Facility.
The Credit Facility is collateralized by loans from our portfolio companies, and includes an advance rate of approximately 55% of eligible loans. The Credit Facility contains covenants that, among other things, require us to maintain a minimum net worth and to restrict the loans securing the Credit Facility to certain dollar amounts, to concentrations in certain geographic regions and industries, to certain loan grade classifications, to certain security interests, and to certain interest payment terms. Citigroup has an equity participation right through a warrant participation agreement on the pool of loans and warrants collateralized under the Credit Facility. Pursuant to the warrant participation agreement, we granted to Citigroup a 10% participation in all warrants held as collateral. However, no additional warrants are included in collateral subsequent to the facility amendment on May 2, 2007. As a result, Citigroup is entitled to 10% of the realized gains on the warrants until the realized gains paid to Citigroup pursuant to the agreement equals $3,750,000 (the “Maximum Participation Limit”). The Obligations under the warrant participation agreement continue even after the Credit Facility is terminated until the Maximum Participation Limit has been reached. During the nine months ended September 30, 2007, we recorded an additional liability and reduced the unrealized gains by approximately $214,000 to account for Citigroup’s participation in unrealized gains in the warrant portfolio. The value of their participation right on unrealized gains in the related equity investments since inception of the agreement was approximately $590,000 at September 30, 2007 and is included in accrued liabilities and reduces the unrealized gain we recognized at September 30, 2007. We have paid Citigroup approximately $71,000 during the nine months ended September 30, 2007 and $367,000 since inception of the agreement under the warrant participation agreement thereby reducing our realized gains by that amount.
At September 30, 2007, we, through our SPE, had transferred pools of loans and warrants with a fair value of approximately $220.7 million to Hercules Funding Trust I and had drawn $32.2 million under the Credit Facility. Transfers of loans have not met the requirements of SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, for sales treatment and are, therefore, treated as secured borrowings, with the transferred loans remaining as investments and the related liability recorded in borrowings. The average debt outstanding under the Credit Facility for the three and nine-month periods ended September 30, 2007 was approximately $20.8 and $52.8 million, respectively, and the average interest rates were approximately 6.69% and 6.49% respectively.
In January 2005, we formed HT II and HTM. HT II is licensed as a SBIC. HT II borrows funds from the SBA against eligible investments and additional deposits to regulatory capital. Under the Small Business Investment Act and current SBA policy applicable to SBICs, an SBIC can have outstanding at any time SBA guaranteed debentures up to twice the amount of its Regulatory Capital. As of September 30, 2007, the maximum statutory limit on the dollar amount of outstanding SBA guaranteed debentures issued by a single SBIC is $127.2 million, subject to periodic adjustments by the SBA. With $63.6 million of Regulatory Capital as of September 30, 2007, HT II has the current capacity to issue up to a total of $127.2 million of SBA guaranteed debentures, subject to the payment of a 1% commitment fee to the SBA on the amount of the commitment. Currently, HT II has paid commitment fees of approximately $1.3 million and has a commitment from the SBA to issue a total of $127.2 million of SBA guaranteed debentures, of which $19.8 are outstanding as of September 30, 2007. There is no assurance that HT II will draw up to the maximum limit available under the SBIC program.
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Dividends
The following table summarizes our dividends declared and paid on all shares, including restricted stock, to date:
Date Declared
Record Date
Payment Date
October 27, 2005
December 9, 2005
April 3, 2006
July 19, 2006
October 16, 2006
February 7, 2007
May 3, 2007
August 2, 2007
On November 1, 2007, we announced that our Board of Directors approved a dividend of $0.30 per share to shareholders of record as of November 16, 2007 and payable on December 17, 2007. Distributions in excess of our current and accumulated earnings and profits would be treated first as a return of capital to the extent of the stockholder’s tax basis, and any remaining distributions would be treated as a capital gain. The determination of the tax attributes of our distributions is made annually as of the end of our fiscal year based upon its taxable income for the full year and distributions paid for the full year, therefore a determination made on a quarterly basis may not be representative of the actual tax attributes of our distributions for a full year. If we determined the tax attributes of its distributions year-to-date as of September 30, 2007, 98.1% would be from ordinary income and 1.9% would be a return of capital for stockholders, however there can be no certainty to stockholders that this determination is representative of what the tax attributes of its 2007 distributions to stockholders will actually be. Stockholders should read any written disclosure accompanying a dividend payment carefully and should not assume that the source of any distribution is our taxable ordinary income or capital gains.
Critical Accounting Policies
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and revenues and expenses during the period reported. On an ongoing basis, our management evaluates its estimates and assumptions, which are based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from those estimates. Changes in our estimates and assumptions could materially impact our results of operations and financial condition.
Valuation of Portfolio Investments. The most significant estimate inherent in the preparation of our consolidated financial statements is the valuation of investments and the related amounts of unrealized appreciation and depreciation of investments recorded.
As a BDC, we invest primarily in illiquid securities, including debt and equity-related securities of private companies. Our investments are generally subject to some restrictions on resale and generally have no established trading market. Because of the type of investments that we make and the nature of our business, our valuation process requires an analysis of various factors. Our valuation methodology includes the examination of, among other things, the underlying investment performance, financial condition and market changing events that impact valuation.
At September 30, 2007, approximately 93% of our total assets represented investments in portfolio companies, of which greater than 98% are recorded at fair value by the Board of Directors. Value, as defined in Section 2(a) (41) of the 1940 Act, is (i) the market price for those securities for which a market quotation is readily available and (ii) for all other securities and assets, fair value is as determined in good faith by the Board of Directors. Since there is typically no readily available market value for the investments in our portfolio, we value substantially all of our investments at fair value as determined in good faith by our board pursuant to a valuation policy and a consistent valuation process. Due to the inherent uncertainty in determining the fair value of investments that do not have a readily available market value, the fair value of our investments determined in good faith by our board may differ significantly from the value that would have been used had a ready market existed for such investments, and the differences could be material.
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There is no single standard for determining fair value in good faith. As a result, determining fair value requires that judgment be applied to the specific facts and circumstances of each portfolio investment. Unlike banks, we are not permitted to provide a general reserve for anticipated loan losses. Instead, we must determine the fair value of each individual investment on a quarterly basis. We will record unrealized depreciation on investments when we believe that an investment has decreased in value, including where collection of a loan or realization of an equity security is doubtful. Conversely, where appropriate, we will record unrealized appreciation if we believe that the underlying portfolio company has appreciated in value and, therefore, that our investment has also appreciated in value.
With respect to private debt and equity securities, each investment is valued using industry valuation benchmarks, and, where appropriate, the value is assigned a discount reflecting the illiquid nature of the investment, and our minority, non-control position. When a qualifying external event such as a significant purchase transaction, public offering, or subsequent debt or equity sale occurs, the pricing indicated by the external event will be used to corroborate our private debt or equity valuation.
Income Recognition.Interest income is recorded on the accrual basis and is recognized as earned in accordance with the contractual terms of the loan agreement to the extent that such amounts are expected to be collected. Original Issue Discount, “OID,” initially represents the value of detachable equity warrants obtained in conjunction with the acquisition of debt securities and is accreted into interest income over the term of the loan as a yield enhancement. When a loan becomes 90 days or more past due, or if management otherwise does not expect the portfolio company to be able to service its debt and other obligations, the Company will, as a general matter, place the loan on non-accrual status and cease recognizing interest income on that loan until all principal has been paid. However, Hercules may make exceptions to this policy if the investment has sufficient collateral value and is in the process of collection. There were no loans on non-accrual status as of September 30, 2007, or as of September 30, 2006.
Paid-In-Kind Income. Contractual paid-in-kind (PIK) interest, which represents contractually deferred interest added to the loan balance that is generally due at the end of the loan term, is generally recorded on the accrual basis to the extent such amounts are expected to be collected. We will generally cease accruing PIK interest if there is insufficient value to support the accrual or we do not expect the portfolio company to be able to pay all principal and interest due. To maintain our status as a RIC, PIK income must be paid out to stockholders in the form of dividends even though we have not yet collected the cash. Amounts necessary to pay these dividends may come from available cash or the liquidation of certain investments. For the three and nine-month periods ended September 30, 2007, approximately $134,000 and $209,000 in PIK income was recorded. There was no PIK income recorded in prior periods.
Fee Income. Loan origination and commitment fees received in full at the inception of a loan are deferred and amortized into fee income as an enhancement to the related loan’s yield over the contractual life of the loan. Loan exit fees to be paid at the termination of the loan are accreted into fee income over the contractual life of the loan. These fees are reflected as adjustments to the loan yield in accordance with FAS 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring loans and Initial Direct Costs of Leases.
Stock-Based Compensation. We have issued and may, from time to time, issue additional stock options to employees under our 2004 Equity Incentive Plan. We follow Statement of Financial Accounting Standards No. 123 (revised 2004),Share-Based Payments (“FAS 123R”), to account for stock options granted. Under FAS 123R, compensation expense associated with stock-based compensation is measured at the grant date based on the fair value of the award and is recognized.
Recent Accounting Pronouncements
In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109”, which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 became effective as of January 1, 2007.
We conducted a review of all open tax year’s income recognition and expense deduction filing positions and income tax returns filed (federal and state) for determination of any uncertain tax positions that may require recognition of a tax liability. This review encompassed an analysis of all book/tax difference adjustments as well as the timing of income and expense recognition for all tax years still open under the statute of limitations. As a result, we determined that it is more likely than not that each tax position taken on a previously filed return or to be taken on current tax returns will be sustained on examination based on the technical merits of the positions and therefore, no recognition of a tax liability on an uncertain tax position for FIN 48 purposes is anticipated.
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In September 2006, the FASB issued Statement on Financial Accounting Standards No. 157, Fair Value Measurements. This standard clarifies the definition of fair value for financial reporting, establishes a framework for measuring fair value and requires additional disclosures about the use of fair value measurements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. As of September 30, 2007, we do not believe the adoption of FAS 157 will impact the amounts reported in the financial statements, however, additional disclosures will be required about the inputs used to develop the measurements of fair value and the effect of certain of the measurements reported in the statement of operations for a fiscal period.
We are subject to financial market risks, including changes in interest rates. As of September 30, 2007, 48 of our loans in our portfolio were at fixed rates and 36 loans were at variable rates. Over time additional investments will be at variable rates. We may, in the future, hedge against interest rate fluctuations by using standard hedging instruments such as futures, options, and forward contracts. While hedging activities may insulate us against changes in interest rates, they may also limit our ability to participate in the benefits of lower interest rates with respect to our borrowed funds and higher interest rates with respect to our portfolio of investments. Interest rates on our borrowings are based on LIBOR. At September 30, 2007, the borrowing rate under the Credit Facility was LIBOR plus 1.20% and the borrowing rate under the SBA facility was approximately 5.5%. In addition, the SBA charges an annual fee of 0.906%.
Disclosure Controls and Procedures
Our chief executive and chief financial officers, under the supervision and with the participation of our management, conducted an evaluation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. As of the end of the period covered by this quarterly report on Form 10-Q, our chief executive and chief financial officers have concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms, and that information required to be disclosed by us in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its chief executive and chief financial officers, as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting
There have been no changes in our internal control over financing reporting, as defined in Rules 13a-15(f) and 15d-15(f) of the Securities Exchange Act of 1934, that occurred during the Company’s most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II: OTHER INFORMATION
From time to time, we may be party to certain legal proceedings incidental to the normal course of our business including the enforcement of our rights under contracts with our portfolio companies. While the outcome of these legal proceedings cannot at this time be predicted with certainty, we do not expect that these proceedings will have a material effect upon our financial condition or results of operations.
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Important risk factors that could cause results or events to differ from current expectations are described in Part I, Item 1A “Risk Factors” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. These factors are supplemented by the following:
Our financial results could be negatively affected if a significant portfolio investment fails to perform as expected.
Our total investment in companies may be significant individually or in the aggregate. As a result, if a significant investment in one of more companies fails to perform as expected, our financial results could be more negatively affected and the magnitude of the loss could be more significant than if we made smaller investments in more companies. The following table shows the fair value of investments held at September 30,2007 that are greater than 5% of net assets:
IKANO Communications, Inc.
Tectura Corporation
IKANO Communications provides global IP network and application solutions; private-label Internet services, including dial-up, DSL, and high-speed wireless. Additionally, the Company offers Web and mail hosting; server-side filtering; branded dynamic portal development; branded customer service and technical support; automated accounting; and Web acceleration.
Tectura Corporation provides business value and competitive advantage to more than 4,000 clients worldwide through its Microsoft integrated business solutions. With successful implementations in over 50 countries, Tectura is a leading global provider of integrated business solutions to mid-market companies and large enterprise divisions.
Our financial results could be negatively affected if these portfolio companies or any of our other significant portfolio companies encounter financial difficulty and fail to repay their obligations or to perform as expected.
Our financial results could be negatively affected if we are unable to recover our principal investment as a result of a negative pledge on the intellectual property of our portfolio companies.
In some cases, we collateralize our investments by obtaining a first priority security interest in a portfolio companies’ assets, which may include their intellectual property. In other cases, we may obtain a first priority security interest in a portion of a portfolio company’s assets and a negative pledge covering a company’s intellectual property and a first priority security interest in the proceeds from such intellectual property. In the case of a negative pledge, the portfolio company cannot encumber or pledge their intellectual property without our permission. In the event of a default on a loan, the intellectual property of the portfolio company will most likely be liquidated to provide proceeds to pay the creditors of the company. As a result, a negative pledge may affect our ability to fully recover our principal investment. In addition, there can be no assurance that our security interest in the proceeds of the intellectual property will be enforceable in a court of law or bankruptcy court.
At September 30, 2007, approximately 29 of our portfolio company loans were secured by a first priority security in all of the assets of the portfolio company and 41 portfolio company loans were prohibited from pledging or encumbering their intellectual property.
During the three months ended September 30, 2007, we issued 125,236 shares of common stock under our dividend reinvestment plan pursuant to an exemption from the registration requirements of the Securities Act of 1933. The aggregate offering price for the shares of common stock sold under the dividend reinvestment plan was approximately $1.5 million.
On July 26, 2006, our Board of Directors approved additional retainer fees for each of our non-interested directors, each of whom elected to receive a portion of their retainer fees in shares of our common stock in lieu of cash. As a result, during the three months ended September 30, 2007, we issued the following number of our shares of our common stock to each non-interested director in lieu of the additional retainer fees: Mr Badavas received 1,666 shares of our common stock in lieu of approximately $22,508 of additional retainer fees. We issued these shares pursuant to an exemption from the registration requirements of the Securities Act of 1933. As of September 30, 2007, Messrs. Chow and Woodward have received the total compensation due them for the additional retainer fees. Mr. Badavas is due additional retainer fees.
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Not applicable.
Not applicable
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Exhibit
Number
Description
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SIGNATURES
Pursuant to the requirements of the Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Manuel A. Henriquez
Chairman, President, and Chief Executive Officer
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EXHIBIT INDEX
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